Regulator's general failure is to blame for carnage now afflicting Irish households

This week, shareholders at AIB vote to accept a Government recapitalisation. The Financial Regulator could have done more to prevent this painful outcome, according to
EUGENE McERLEAN

“NO REGULATORY authority, including the Financial Regulator, Central Bank or indeed any other part of the international financial system anticipated the scale of the meltdown in international markets or the dismantling of the interbank credit markets which arose from the collapse of Lehman Brothers.”

This is the surprising admission made by the Financial Regulator in his opening statement to the Joint Committee on Economic and Regulatory affairs on October 14th last year and which has been continuously repeated by some politicians and commentators as an excuse to explain our current banking crisis.

The illusion at the heart of this statement is that it answers a question that was never asked. No one has ever accused the regulator of failing to predict the collapse of Lehman. The notion that the inability to predict the specific trigger of the financial collapse ie Lehman’s bankruptcy, absolves the regulator from responsibility to identify and warn us that both international and national financial conditions were perilous is beguiling false logic at its most dangerous. To assume that everything would have been fine if Lehman Brothers had survived is at best naive.

One does not need the benefit of 20/20 hindsight to establish that international financial conditions were precarious in 2008 prior to the Lehman collapse. The issue of financial catastrophe was frequently discussed on CNBC and Bloomberg throughout the course of the past couple of years, perhaps most notably when CNBC anchor Jim Cramer lost the plot on live TV as he pleaded with the Fed to take action in the face of imminent meltdown.

More significantly for the Irish economy, the simple statistics which are now becoming clear – and which were previously only available to the regulator – about the overconcentration of lending by banks to small numbers in the construction and property development sectors should have had the alarm bells ringing. No one has summarised the basic credit risk issues better than former US Federal Reserve board member Susan Schmidt Bies as long ago as June 2005 when she said in relation to the US regulator’s attitude to the dangers of bank over-lending: “Credit risk has been the leading cause of bank failures over the years and remains the biggest risk for most financial institutions . . . as the real estate lending cycle matures and lender competition increases, banking supervisors tend to worry. In particular, in the commercial and residential real estate sectors, we worry that borrowers could become increasingly speculative, buying beyond their means and hoping for asset price appreciation – whether they are buying for their own use or strictly for the sake of investment. We worry that competitive pressures could drive banks to lower their underwriting standards, implicitly encouraging such speculation. And we worry that, in the inevitable downturn, credit quality could deteriorate to the extent that some banks could experience significant losses.”

There is little evidence the Irish regulator either shared or acted upon any of the speculative lending concerns outlined by Schmidt Bies. The basis of its advice to the Government at the end of September 2008 appears to have been that this was a liquidity problem, not a credit problem, and that the banks were well-capitalised to meet any loan losses. If the acute liquidity issues experienced by the Irish banks had been analysed as indications of an underlying deterioration in credit quality, then a preferable series of options may have been available to help the Government manage the crisis.

However, even if one assumes the absence of the obvious warning indicators and acknowledges the inability to predict the Lehman meltdown, the regulator cannot absolve itself from responsibility for the economic carnage which now afflicts practically every family in Ireland. We rely on the self-styled “world class” regulator to do what we normally do not do; it is one of its main functions to anticipate and prepare for the unexpected.

In his book
The Black Swan, Nassim Nicholas Taleb tells the story of how it was originally believed that all swans were white. That is until an explorer discovered a black swan. Taleb draws the clear analogy with financial markets, which historically are littered with black swan events of which the Lehman Brothers collapse is only the latest. Consequently, it is an insufficient argument to suggest that we were all equally guilty, that we all enjoyed the benefit on the way up and so we all have to suffer the pain on the way down.

We were entitled to rely on those in charge of supervising the financial markets and who had access to substantial aggregate information provided by the banks to afford us some protection. Had we known what they knew, we would surely not have taken the same borrowing decisions.

The inability of the regulator to predict the precise catalyst of the financial meltdown should not excuse the regulator from responsibility to ensure the banks under its supervision were best-placed to deal with any shock to the financial system. It seems perfectly clear to the man in the street that the system was not well-prepared because of the failure of the regulator to impose appropriate disciplines on the banks. It is self-evident this lack of supervisory discipline allowed unprecedented balance sheet growth and disproportionate exposure to the property and construction sectors.

Consequently, it was entirely predictable that, in the event of a crisis, the Irish financial system would be excessively exposed to catastrophic risk. It is the failure of the regulator to either acknowledge this or accept any responsibility which gives rise to a lack of confidence in the regulator’s ability to either predict or manage the inevitable next black swan event in Irish banking.